Financial analysis

Hold, Sell, or Exchange?

Consider Financial and Nonfinancial Issues When Determining Whether to Sell an Investment Property.

Not that long ago, holding real property was limited to elite individuals and institutions -- the original “land lords” -- whose estates were passed down from generation to generation. The general population's entry into this once-rarefied arena has allowed a broad spectrum of individuals to accumulate wealth. Ironically, many individuals have discovered that perhaps the most challenging aspect of owning real estate is, in fact, deciding when it is time to sell it.

The decision to sell is complicated further by the fact that, at the same time, another presumably knowledgeable investor who also has studied the property and market has concluded that the time is right to acquire it.

What types of analyses can be used to assist in determining if the time is right to sell? It depends on the situation. For example, a buyer such as a real estate investment trust with access to capital at highly favorable rates may be able to make an offer substantially higher than what otherwise would be achievable. Or a late-term tax-deferred exchanger may offer a higher price in order to avoid a large tax penalty. In such cases, analysis much beyond the arithmetic computations of buy, sell and reinvest, or exchange almost is unnecessary.

But in more typical situations where the offer is on par with the current market, financial analysis often is just one piece of the puzzle. In these cases, what ultimately tips the scales decisively one way or the other frequently is found through an analysis of the nonfinancial influences.

Of course, even the best-laid plans can fall victim to circumstances. Sometimes, an owner's personal needs are so compelling that the decision to sell is a foregone conclusion. The following discussion assumes that this is not the case and that all options remain open.

Financial Analysis The financial analysis of whether or not to sell a property should include several components.

Tax Considerations. The complex tax code can make it risky to calculate after-tax yields. However, because code provisions allow for tax deferral on exchanges, tax consequences must be considered when comparing hold, sell, or exchange options. An exchange permits the use of pretax dollars as a down payment, but it extracts a penalty in the amount of depreciation that can be taken on the property received in the exchange. A pretax comparison is not merely misleading -- it is patently wrong.

If substantial suspended losses exist, they could offset the gain on an outright sale. In this event, investors should be careful not to inadvertently create an exchange.

Measuring the Yield for Continuing to Hold. Inexperienced investors often find the first step in the analysis to be the most confusing: determining the current investment base. This is not the original down payment but the amount that could be freed up by a sale at the current time. As stated above, after-tax dollars based on the given tax assumptions must be used.

The next step is to realistically project what is likely to occur in the future if the owner continues to hold the existing property. This requires compiling a pro forma of income and expenses for a given period of time, such as five or 10 years. With historical figures, investors can make an educated guess for potential positive or negative changes in future value.

Basically, three factors can improve the ongoing yield: increasing rental rates, decreasing capitalization rates, and decreasing interest rates.

Investors also should look at income trends. If increases are stipulated, the task is easy. Otherwise, it may be necessary to estimate future changes in the Consumer Price Index, analyze tenants' sales volumes for percentage clauses, or perform a rent survey of competitive properties in the area. These estimates must be as realistic as possible, since if they are unachievable, the entire analysis will be an exercise in futility.

After establishing a reasonable estimate of future income, an investor must make an assumption about the market's projected cap rate for the proposed year of resale. This number is an educated guess at best, but it is essential.

By using computer analysis, an investor can calculate the annual after-tax income, and using the internal rate of return, show what the yield would be for holding the existing property. In addition, by adding the after-tax cash-flow total to the net proceeds on resale, the total dollars that will be received -- accumulated wealth -- also can be calculated.

Measuring the Yield for Selling and Reinvesting. To make a valid comparison between holding or selling and reinvesting, it is necessary to select an alternative property to be considered as a replacement property. The ideal property is one that, from a nonfinancial viewpoint, is as good or better for the investor than the existing property.

In this case, the property's basis is the total investment, and depreciation is determined by the current tax laws and the established value of the improvements.

Using general market assumptions that are consistent with those used in the hold analysis, an investor should establish an income-and-expense pro forma and estimate the cap rate for future resale value.

Measuring the Yield for an Exchange. Using the same replacement property from above, the effects of an Internal Revenue Code Section 1031 exchange can be determined. The pro forma and cap rates already have been established, but the exchange requires the following adjustments for unique tax consequences.

Carry-over basis is the basis in the property being given up. It is carried forward to the exchange property, adjusted upward for additional investment in the form of loans or cash (exchanging into a larger property), or adjusted downward for profit taken out (exchanging into a smaller property). The new basis is multiplied by the percentage of building improvements (building-to-land ratio calculated in the sell-and-reinvest example) to indicate the depreciable amount, using the current tax-code term.

Nonfinancial Influences
Setting aside the results of the yield analysis and considering other influences, it is not unusual to discover that an initially well-suited investment is no longer a good fit five to 10 years later, no matter what the financial yield may be. To determine how well an investment still fits with current goals, investors should consider the following questions about nonfinancial influences.

Market Area. How does the investor feel about the area in which the property is located? Has the surrounding area matured so much that the upside potential factored into the original purchase decision already has been realized? Alternatively, have initial projections proven to be overly optimistic or even wrong? If it is the latter, can the investor create or even maintain value going forward?

Property Goals. What are the investor's future goals for the property? If the decision is made to continue to hold, the investor essentially is choosing to buy the property back at the offering price. Standard escalations aside, are there 10 or more ways to anticipate being able to either increase income, lower vacancy/turnover, or trim operating expenses at a level that outperforms competing properties? If not, the investment may have reached a plateau in value, based on operation/management style.

Alternative Properties. Are there alternative properties to consider? New opportunities surface constantly for investors that actively seek them. With a little detective work and some pricing assistance, investors can create an opportunity by directly contacting owners of unlisted properties with unsolicited offers.

In an exchange, an investor is granted only 45 days to identify a short list of “upleg” properties -- those being considered for purchase. Owners that are more concerned about finding the perfect exchange property than with achieving top dollar from their “downleg” may find the best time to sell is when a preferable replacement property becomes available.

Changed Goals. How have the investor's goals changed since acquiring the property? How closely does the property's profile fit the investor's lifestyle and future investment goals? For example, if the investor has been moving slowly from a strict cash-flow focus to more pride of ownership, this should be factored into the decision to sell.

Although these points may seem obvious, they can create a subtle barrier because some people tend to wave aside the obvious. To keep this tendency in check, investors should prepare a weighted analysis chart that considers various alternatives related to different property scenarios. Once the performances have been rated, the scores are multiplied by the particular weight assigned to each issue to find the total score for each alternative.

Drawing a Conclusion
Having calculated the relevant financial rates of return and reduced other issues down to a comparative figure, the investor now should be ready to make a decision. With any luck, both results will point to a clear best choice. If not, no ready rule of thumb exists to determine the winner. Just as both a buyer and a seller can be right when they evaluate the same property and come to the opposite conclusions, so the stamp of personal judgment remains the most important part of any investment decision.

Case Study
To put these guidelines in perspective, consider the following situation that recently occurred.

A $3 million offer for a California apartment building was received from a buyer working to complete a 1031 exchange. Although the property was not on the market, it was determined that the offer represented better than a 10 percent premium over what could be supported, based on the most favorable comparable sales for the area. The building's owner, a partnership, had to decide whether to continue to hold, sell and reinvest, or exchange into a new property. As usual with an exchange, the allotted response time was short.

The property had been well-maintained for the area. After several years of erratic vacancy numbers and significant turnover rates due to demographic and economic changes, the property's vacancy rate had taken a dramatic turn for the better. Indications were that the neighborhood was beginning to stabilize and be revitalized, fostering hopes that future increases in rental rates might be possible. Nonetheless, the area's perception had been tainted by the past problems, and widespread fears remained that it could re-enter its decline. Both of these issues placed a limit on investor demand and increased the level of risk in continuing to hold.

The property generally produced an acceptable income stream, but it began to present greater operational challenges as it aged. The partnership had decided to exchange gradually into higher-quality commercial projects as favorable opportunities presented themselves. To resolve long-standing partnership issues if this particular property were sold, certain individuals would withdraw their share of the proceeds prior to reinvestment.

While reviewing current listings, letters were sent to owners of 40 properties that had been identified as potential targets in previous exchange transactions. One owned an office building in a desirable area of Pasadena, Calif.; she recently had moved to Florida and had just begun investigating the possibility of selling the building. She faced a sizable rollover potential in the coming 18- to 24-month period and did not feel that she could continue to run the building in the manner that would ensure a good retention rate. She had purchased the building from a lender during a down period in the market and sought to cash out with a substantial profit, pay her taxes, and put the money into other non-real estate ventures.

The property was a 20,000-square-foot commercial building built in 1992 as the headquarters of an architectural firm. The firm currently leased back 8,500 sf for a seven-year term. The balance of the space was leased to five other tenants on three- to five-year terms. The property was located in a historic preservation district, but it was one of only a few office and retail structures that had been built as in-fill within the past 10 years. The building had received three architectural awards for design and the quality of its construction had been confirmed by an engineering inspection. Tenant improvements, moreover, were found to be unusually attractive and over standard for the market, but not special purpose in nature.

Due to the absentee status of the current landlord, the building suffered from some deferred maintenance. This was investigated and determined to be correctable. The seller agreed to set aside funds for these corrections that would allow the buyer to make required repairs after purchase. It was determined that these improvements, and the more hands-on style of management favored by the client, would go a long way in ensuring continued high occupancy.

Case Study Financial Analysis
The accompanying financial analysis chart shows the assumptions and calculations involved in arriving at the various IRRs for the options that were under consideration.

Based on a continue-to-hold yield of 7.94 percent IRR and accumulated wealth of $901,721 (the buyer added $24,800 cash down payment) and a sell-and-reinvest yield of 18.93 percent IRR and accumulated wealth of $1,410,633, clearly, on a financial basis, the existing property should be sold and the new property should be acquired.

However, a second alternative is available to real estate investors -- a tax-deferred exchange. The yield for exchange is 21.91 percent IRR and accumulated wealth of $1,279,925. The exchanger removed $92,025 cash ($122,700 less $30,675 gain tax paid).

In this case, the decision to exchange rather than to sell outright and reinvest was based on the financial consideration of adding or removing cash. The partnership previously had elected not to invest additional capital and was prepared to pay the nominal tax on the cash taken out.

The clients also considered other nonfinancial influences in their decision.

While the analysis produced a clear recommendation in this case, it is important to note that, although there were in effect three buyers and three sellers, each came away convinced that they had bought and sold at the right time.

This raises several interesting questions. Because it was the right time for the partnership to sell, does this mean that the individual who purchased the apartment building made the wrong decision? For him, no. Although he paid somewhat more than what the seller determined was market for the building, the buyer was able to satisfy his exchange and had a plan to optimize the building to the new demands of the area.

Similarly, while it is clear that the owner of the Pasadena office building made a hefty profit based on the partnership's purchase price, does this mean that the partnership made the wrong decision in buying it?

Not at all. The seller had made what turned out to be a well-timed investment when she originally purchased the property, and she realized that gain. The partnership was able to reposition into a pride-of-ownership asset that is well-suited to a hands-on style of management. At the same time, the partners simplified the partnership structure and reduced the overall anxiety level.

So while the answer to the question, “Is now the right time to sell?” remains, “It depends,” it should be comforting to know that what it depends on most is the investor. As always, investors should consider a sale or purchase not as an isolated event but as part of an overall investment plan.

Letty M. Bierschenk, CCIM, Kurt R. Bierschenk, CCIM, and William C. Bierschenk, CCIM

Letty M. Bierschenk, CCIM, Kurt R. Bierschenk, CCIM, and William C. Bierschenk, CCIM, are members of the Bierschenk Group in Los Angeles. They provide brokerage, advisory, and capital services to individual and corporate clients. Contact them at (310) 573-3615 or


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